The Impact of a Weaker Dollar on the Gulf

Dollar weakness has been the overriding trend in currency markets this year. We expect it to dominate for at least another year until the US current account deficit is brought down to more sustainable levels. Indeed we estimate that this process will require a further 20% fall in the trade weighted dollar, which will see the euro peak at 1.30 and the yen reach 90. Currencies are rarely one way bets and the dollar could temporarily strengthen in the new year as it did over the summer months, but the medium downward trend is clear.

Since the Gulf currencies are pegged to the US dollar, as the dollar declines in value so do they. The dirham, dinar and riyal have all touched fresh lows against the major currencies. The dollar's fall and future direction will have an important impact on all the Gulf economies.

The most visible impact of a weaker dollar in the region has been in the increase in the price of imported goods. The Gulf imports the majority of its goods from Asia followed by the Eurozone. The US only accounts for 13% of the Gulf Co-Operation Council's total imports. Higher prices raise costs for importers and reduce the spending power of Gulf consumers. Sectors already facing supply squeezes, such as construction materials, have been particularly hard hit. Global competitive pressures, the open nature of the Gulf economies and the relative ease with which local companies can switch to lower cost suppliers will prevent runaway inflation, but consumers will need to prepare for higher prices next year.

As well as increasing the cost of certain imported goods a weaker dollar also reduces the relative value of US investments and assets. This of course can be offset by capital gains if the assets rise in value. Although regional assets are also falling in foreign currency terms, the relative outperformance of the local stock markets has easily compensated. Some evidence suggests that the dollar's fall has accelerated the trend of regional investors repatriating money out of the US and instead bringing it home. The Bank of International Settlements reported that Gulf and other OPEC investors repatriated USD 13bn in H1 2003, more than twice the total amount for 2002.

OPEC has certainly become concerned about the dollar's fall. At last week's meeting the Cartel's members made clear that to compensate for the dollar's decline they would be trying to maintain prices above USD 25 per barrel rather than within the official target range of USD 22 to USD 28 per barrel. Indeed the US dollar's decline is one of the reasons's why dollar denominated oil prices look so high. Oil prices in euros are at the same level as the beginning of 2002, 24 euros, and well below the highs of 2003. Oil, like gold, is a global commodity that just happens to be priced in dollars. As the dollar falls, oil prices tend to rise to compensate.

Inevitably some analysts began to talk up the likelihood of OPEC switching the pricing of oil. A complete dollar collapse would make this a possibility, but the Cartel is likely to stick to dollar for the medium term. OPEC has maintained its dollar pricing through periods of dollar weakness before and is likely to do so again. As one Oil Minister pointed out what would happen if they switched into pricing in euros and the dollar began to strengthen?

This logic is likely to dominate the thinking of regional policymakers when discussing the current dollar pegs. The USD peg has worked remarkably well in providing macro economic stability over the last fifteen to twenty years and is unlikely to be easily abandoned. That said, a strong case can be made for considering moving from a dollar peg to a basket of currencies, (of say the euro, yen and dollar) similar to the system Kuwait operated before 2003. Asia is the Gulf's largest and fastest growing trade partner and US interest rates are clearly too low for the booming Middle East economies. This is a medium term issue. In the short term a sustained dollar decline throughout next year may prompt some countries to contemplate repegging to USD at a higher level.

We have argued elsewhere that global currency markets are undergoing a dollar free diet in an attempt to end dollar dependency. The Middle East is likely to wait and see how painful the diet, and how successful the results, before abandoning a twenty-year relationship.